Class Lecture Notes - Lecture #18 11/25/2003
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  • 4/25/03 changed per Scott Dennis (IRR objectives changed)

Class Lecture Notes - Lecture #18 11/25/2003 Presentation Transcript

  • 1. Real Estate and Institutional Investment Strategies
    • Lecture Map
      • Institutional Portfolio Management
      • Role of Real Estate in an Investment Portfolio
      • Asset selection within the Real Estate Asset Class
        • What do institutions want from their real estate investments?
        • Is there a ‘best way’ to select real estate investments?
  • 2. Portfolio Management Theories
    • Efficient Frontier Theory
      • Optimize combination of assets along the “efficient frontier” to maximize returns relative to acceptable level of risk
      • Diversify portfolio to reduce correlation of returns, thereby reducing risk as much as possible given targeted return
    • Immunization Strategies
      • Select base portfolio to cover projected stream of liabilities
      • Balance of the portfolio invested to enhance returns
  • 3. The Efficient Frontier
    • In theory, investors should maximize returns at the margin for the amount of risk they are willing to bear
    • “ Risk” in this case is measured by the volatility of returns and the correlation - or lack thereof - of relative returns across asset classes
    • Assets are worth more in combination than individually if optimally combined based on the covariance of their returns
  • 4. Constructing an Efficient Portfolio
    • Choose the asset mix of your portfolio
      • Growth stocks
      • Value stocks
      • Fixed Income
      • Real Estate
        • Direct
        • Commingled Funds
        • REITs
    • Change the asset mix change over time
      • Market Timing
      • Style Rotation
      • Change in target risk and return
  • 5. Special Challenges for Real Estate with the Efficient Frontier Model
    • In practice, it is very difficult to measure real estate’s correlation with other assets
      • Historical data is not as robust as it is for stocks, bonds, making measurement difficult
      • Private real estate markets are also fragmented, inefficient, illiquid
        • Some properties correlate well with bonds – single credit net lease deals, multi-family
        • Others exhibit high volatility – hotels, suburban office
        • Performance can vary significantly between properties, markets
  • 6. Other Challenges of the Model
    • The efficient frontier ignores pension liabilities
      • Assets are selected based on what they contribute to the total return goals of the portfolio
      • Plan sponsors would also like to generate income that matches their liabilities
      • Liabilities are gaining focus today because of the losses of recent years
    • Benchmarking against target returns and indexes is also problematic for real estate
      • Most targets are annual
      • Most indexes are benchmarked quarterly
      • Real estate is a long term asset!
  • 7. Portfolio Immunization
    • Investment strategy based on meeting planned and/or projected liabilities versus a target rate of return
    • Methodology splits the portfolio into two pieces:
      • Core investments indexed to liability streams
        • Generates income to match size, timing of liabilities
        • Ties well with fixed income investments
      • Balance of the portfolio invested to enhance total return
        • Alternative assets, equities, etc.
    • Works best with fully and/or overfunded pension plans
      • Underfunded plans are by definition behind the total return curve in meeting even known liabilities
        • Lots of plans are underfunded today, however -> should they take more risk to meet obligations?
  • 8. Portfolio Immunization (cont.)
    • Immunization is getting lots of attention in the portfolio management world today:
      • “Post bubble” phenomenon
        • Institutional portfolios severely hurt by tech boom/bust
        • Portfolio discipline was missing in over-allocation to tech, private equity and venture capital
        • Concern over looming obligations to retiring baby boomers
  • 9. How Big was the Bubble?
  • 10. Other Attractions of Immunization
    • Stop the proliferation of ‘asset classes’
      • Immunization would classify assets by their role in the portfolio as opposed to role in diversification
        • “ what is the job” of each asset?
        • Inflation hedge; current income; long term growth
    • How efficient is asset allocation today anyway?
      • Look at real estate fundamentals vs. pricing
      • Are we creating another bubble of a different type?
  • 11. Why Real Estate Looks So Good in the Immunization World
    • Real estate combines return features of both bonds and stocks with low correlations to those asset classes
      • Current income and total return
      • Same argument used by the efficient frontier model, but for immunizers, the current income provides a hedge against liabilities; growth component offers “alpha”
    • Real estate also offers multiple investment strategies within the asset class to enhance total return
      • Opportunistic plays
      • Property type and sector plays
      • Market selection
  • 12. Role of Real Estate in An Investment Portfolio
    • Regardless of theory, widely agreed today that real estate should be a part of every investor’s portfolio
    • Real estate offers an ideal fit
      • Efficient Frontier -> low correlation
        • -> diversification
        • -> fixed income and appreciation attributes
      • Immunization -> fixed income attributes
            • -> return enhancement opportunities
    • Also generally agreed that investors are on average significantly underweighted in real estate
  • 13. Institutional Real Estate Strategies
    • Involves Selection of Investment Vehicles and Managers
    • Primary Investment Vehicles:
      • Private Equity Real Estate Funds
        • Core
        • Value-Add
        • Opportunistic
      • REITs
        • Market proxies
        • Regional, property type plays
      • Direct Deals
  • 14. Institutional Real Estate Strategies (cont.)
    • Implementation of any strategy is critically dependent upon manager selection
      • Expertise and track record
        • Deal experience
        • History of producing targeted returns
      • Transparency
        • How good, frequent, honest is the reporting?
      • Alignment of Interests
        • Incentive-based reward structure
  • 15. Institutional Real Estate Strategies (cont.)
    • Institutions invest disproportionately in private, direct deals today
      • Public REIT markets, universe of private equity funds too small to accommodate available capital
      • Selection of, relationship with manager is key
        • Real and/or perceived ability to influence operations and outcome of the investment
      • Facilitates periodic rebalancing if needed
        • Less liquidity than a REIT, but more than a fund with a greater degree of control over the asset, exit timing
  • 16. Real Estate Investment Strategies – Moving Beyond the Vehicle
    • Real Estate provides multiple opportunities to enhance returns at the margin in all investment vehicles
      • Stage and/or strategy selection
      • Property type allocation
      • Regional allocation
      • Market Selection
      • Property Selection
    • What are the selection issues?
      • Correlation between strategies
      • Long term economic and demographic shifts
  • 17. Return and Risk Attributes for Investment Stages and Strategies Core Re- capitalization Lease-up, Re-tenanting or Renovation Forward Commitment Development Core Re-capitalization Renovation Lease-up Forward Commitment on Development Development
    • Stable Market
    • Class A & B Properties
    • Prime Location
    • Objective: 8-10% IRR
        • 80% +
    • Leasing Risk
    • JV Structure
    • Retain Control
    • Objective: 10-12% IRR
    • Substantial Initial or Near-term Vacancy
    • Low Initial Yield
    • Objective: 11-13% IRR
    • Major Capital Expenditures
    • Increase Revenues
    • Objective: 11-13% IRR
    • Minimal Construction Risk
    • Minimal Zoning/ Entitlement Risk
    • Fund at Completion
    • Leasing Risk
    • JV or Wholly-Owned
    • Objective: 12-14% IRR
    • Limited Construction Risk
    • Leasing Risk
    • Minimal Zoning and Entitlement Risk
    • Objective: 13-18% IRR
    Development Entity Investing Entity Investing
    • Operating Partner Risk
    • Reduced Level of Control
    • 40-90% Leverage
    • Objective: 18% + IRR
    Risk Attributes Value-Added Strategies
  • 18. Property Type Allocation
    • Office and Industrial properties are most cyclical, most closely reflect economic cycles
      • Office -> either the best or the worst performer. A lagging indicator. Time the cycles, underweight suburban “commodity” deals in general
      • Industrial -> generally outperforms office, more stable returns than office. More of a leading indicator.
    • Retail and Multifamily are considered more stable
      • Retail -> negative correlation with office, good absolute returns. Reflects consumer-driven economy
      • Multifamily -> considered defensive, counter-cyclical. Influenced by demographic trends as well as job growth
  • 19. Regional Allocation
    • Property type selection within regions is important
      • Gets back to economic base analysis!
      • What industries, activities drive the local economy and will be reflected in real estate needs?
    • East and West
      • Higher returns, higher risk
      • More heavily concentrated in office product because of the financial focus of coastal economies
    • Midwest
      • Correlated with the East coast, although more heavily industrial in nature
    • South
      • Low correlations with West, higher risk adjusted returns on average than either coast
      • Long term demographic shifts favor the south
  • 20. Market Selection
    • Drivers of Market Selection:
      • Employment growth and comparative economic strength
      • Ease of adding new supply
      • Historical absorption track record
      • Property preferences -> which do better in given market?
    • International vs. National Markets:
      • Direct comparisons are difficult to make
        • U.S. market is a “traded” market; foreign markets are not
        • Long term holds might favor stability of yield in W. Europe
      • Does the recommended diversification model apply here?
      • Prologis strategy: provide U.S.-style service to customers in foreign markets
      • Goldman approach: move opportunistically in and out of international markets
  • 21. Property Selection
    • Pick your size
      • Smaller assets have historically outperformed larger assets
        • Wider audience offers greater liquidity
        • If your holding period is short, evaluated exit opportunity
    • Pick within asset classes
      • Suburban vs. CBD office
        • CBD considered more stable
      • Regional mall vs. power center vs. neighborhood center
        • Neighborhood center in favor
      • Flex R&D vs. distribution
        • Flex R&D is more cyclical
      • Garden-style multifamily vs. high rise, urban condominium
        • Garden-style considered more generic and defensive
      • Full service, limited service, resort hotels
        • Luxury full service most defensive, resort most cyclical